Incentives for Audit Quality An exploratory review 6 October 2011

Transcription

1 Incentives for Audit Quality An exploratory review 6 October 2011 This is an English translation of the original Dutch text, furnished for convenience only. In the event of any conflict between this translation and the original Dutch text, the latter shall prevail.

2 Netherlands Authority for the Financial Markets (AFM) The AFM promotes fairness and transparency within financial markets. We are the independent supervisory authority for the savings, lending, investment and insurance markets. The AFM promotes the conscientious provision of financial services to consumers and supervises the honest and efficient operation of the capital markets. Our aim is to improve consumers and the business sector s confidence in the financial markets, both in the Netherlands and abroad. In performing this task the AFM contributes to the prosperity and economic reputation of the Netherlands. 2

3 Contents Foreword 4 1 Introduction Background The purpose of the review Source of the information 7 2 Conclusions and Recommendations Conclusions Recommendations 10 3 Execution of the thematic review 12 4 Results by theme Appointment, appraisal, remuneration and sanctioning Independence 21 5 Improvements in policies and procedures 37 6 Future developments 38 Appendix 1 Legal context 39 Independence 39 Appointment, appraisal, remuneration and sanctioning of external auditors 39 Annex 2 Comprehensive overview of the nature of other services 41 3

4 Foreword The Netherlands Authority for the Financial Markets (Autoriteit Financiële Markten, or AFM) promotes the fair and efficient functioning of capital markets, thereby supporting investor confidence in these markets. The AFM s duties include the enforcement of the rules for auditors auditing annual financial reports. The market has to be able to rely on the proper performance of such audits. As part of its ongoing supervision of audit firms, the AFM conducted a thematic review on incentives for audit quality during the first six months of Our review covered all fifteen audit firms whose license includes the performance of statutory audits for public interest entities (PIE licensees). 1 This report sets out the results of our thematic review. This report is set out under the following sections. Section 1 sets out the background and purpose of our thematic review and outlines the source of the information used in our review. Section 2 provides an overview of our conclusions and recommendations. Section 3 provides information on our review process and the scope of our thematic review. Section 4 provides the results of our review by theme, broken down into several topics. Section 5 provides a summary of the improvements in policies and procedures that audit firms have implemented or announced in relation to matters set out in this report. Finally, section 6 describes the future developments in the public discussion about incentives. Appendix 1 to this report provides a summary of the laws and regulations governing independence and the appointment, appraisal, remuneration and sanctioning of external auditors. Appendix 2 provides a comprehensive overview of the types of other services that one or more PIE licensees provided to their audit clients. 2 Contact For more information about the supervision of audit firms, please visit the AFM s website ( under professionals> Audit firms. Any specific questions you may have after reading our report can be raised via (wta@afm.nl), or in writing to the Financial Markets Authority, Attn. Audit Firms Supervision Division, P.O. Box 11723, 1001 GS Amsterdam, The Netherlands or by telephone on +31 (0) Public interest entities (PIEs) include listed companies, credit institutions and insurers. Audit firm and PIE licensee as used in this report often include the Dutch parts of the network to which the audit firm belongs. 2 Audit client within the meaning of Article 1.1(e) of the Supervision of Audit Firms Act (Wet toezicht accountantsorganisaties, or Wta). Audit client as used in this report often includes third parties affiliated with the audit client.

5 1 Introduction 1.1 Background The AFM s Report on general findings regarding audit quality and quality control monitoring 3 of 1 September 2010 announced that the AFM s oversight in 2011 would focus on financial and other incentives for audit quality within audit firms. Following the findings of the above report, the AFM decided to undertake its thematic review Incentives for Audit Quality covering all PIE licensees. Audit firms by nature are organisations with commercial interests. At the same time, audit firms are subject to various statutory and regulatory requirements pertaining to the quality of their services, creating tension for auditors. Discussions in the Dutch Parliament on this subject described this tension as follows: The public function of the auditor s report requires that audits and the resulting auditor s reports are of a high quality. Audit firms are for-profit organisations competing with each other to offer and provide their services. The statutory quality requirement leaves room only for competition on efficiency aspects of the performance of audits. There is a certain tension between these different interests or objectives. 4 The AFM s review of financial and other incentives for audit quality focused on two themes: the independence of audit firms and external auditors, and the appointment, appraisal, remuneration and sanctioning of external auditors. Being able to make objective judgements requires external auditors and audit firms to be independent of their audit clients. The intended users of auditor s reports, i.e., society at large, and the external auditor s client are not one and the same. Auditors must not let their professional judgement be impaired by bias, conflicts of interest or undue influence. 5 If auditors allow this to happen, there is a risk that society at large will have little or no confidence in the quality of audits and the resulting auditor s reports. By being independent, the external auditor shows society at large that he can perform an audit engagement objectively and with integrity. It is therefore necessary that, when conducting an audit, the auditor demonstrates fairness, honesty and integrity, and avoids conflicts of interest. Independence is not an end in itself but a means to ensure and demonstrate the integrity and objectivity of external auditors. It is essential that society at large has an understanding of the independence of external auditors and audit firms. This is crucial to maintaining and safeguarding public confidence in the reliability of financial statements and the function of external auditors. An auditor should not be involved in an audit if there are financial, business, employment or other relationships with an audit client that a reasonable and informed third party having knowledge of all relevant information would consider unacceptable. Independence involves both independence in fact and independence in appearance. Being independent in fact (reflecting an auditor s state of mind) means that the external auditor must be objective towards the individual audit client. Being independent in appearance (reflecting an auditor s actions) requires audit firms and external auditors to avoid all facts and circumstances pointing to a situation where the objectivity of the external auditor or the audit firm may be compromised. Threats 3 Audit as used in this report refers to the statutory audit within the meaning of Article 1.1(p) of the Wta. 4 Explanatory Memorandum to the Supervision of Audit Firms Decree of 16 August 2006, Bulletin of Acts, Orders and Decrees no. 380, 2006, page See Article A-100.4(b) of the Dutch Code of Conduct Regulation for accountants (Verordening Gedragscode, or VGC). 5

6 to independence fall into the following categories: self-interest, advocacy, familiarity, intimidation and self-review. In addition, it is important that there are sufficient incentives within audit firms that promote the quality of audit work, i.e., incentives triggering external auditors to conduct high-quality audit work. This could be achieved by making audit quality an important evaluation criterion in the appointment, appraisal, remuneration and sanctioning of external auditors. Independence and the appointment, appraisal, remuneration and sanctioning of external auditors are areas that fall within the scope of the AFM s statutory ongoing supervision responsibilities, requiring inspections of PIE licensees once every three years. Partly due to the fact that these issues are high on the agenda of, among others, regulators, professional bodies, interest groups of users and legislators, both in the Netherlands and abroad, it is now important to further examine these areas. With a view to improving the quality of audits, the AFM aims to contribute to the public debate on these areas by providing a better understanding of the incentives for audit quality. 1.2 The purpose of the review The aim of the AFM s thematic review was to gain an understanding of how independence and the appointment, appraisal, remuneration and sanctioning of external auditors are addressed in practice. Our review was exploratory in nature, and did not focus on assessing the level of compliance with laws and regulations, or identifying specific violations. The fact that external auditors are paid by their audit clients puts pressure on external auditor independence. The position of the auditor in relation to his audit client and to investors and other users of financial reports is the subject of national and international discussions. This review did not deal with that position. Our review focused on the following situations where there may be a threat to the auditor independence 6 : a combination of statutory audit and other services; business relationships with audit clients; long-term relationships with audit clients; financial interests in audit clients; family and close personal relationships with audit clients; sponsor relationships with and gifts to audit clients; gifts from audit clients; entering into an employment relationship with an audit client; employment relationships with audit clients, or management or supervisory positions at audit clients. The AFM examined the incentives playing a role in the appointment, appraisal, remuneration and sanctioning of external auditors and, in particular, whether and to what extent the quality of statutory audits plays a role. The AFM s aim was to gain an understanding of: the nature and size of the population of external auditors; the way in which the audit firms have implemented their policy regarding the appointment, appraisal, remuneration and sanctioning of external auditors (design and operation); 6 Some of these relationships are included in the Further regulations on auditor independence (Nadere voorschriften onafhankelijkheid openbaar accountant). 6

7 the evaluation criteria used to appoint, appraise and remunerate auditors; the way in which audit firms impose sanctions on external auditors in case of violations and other offences; the relationship between any sanctions imposed on auditors and their appraisal and remuneration. Our review was exploratory in nature. Our findings are generally used as an input into the AFM s riskbased supervision, and can provide the basis for further inspection by the AFM. 1.3 Source of the information The information presented in this report is based on the information provided to the AFM by the audit firms following the AFM s request to provide such information. Some audit firms did not have certain information systematically available in the form requested by the AFM. In such cases, audit firms made specific requests to their external auditors to provide the information requested, or collected this information, manually or otherwise. 7

8 2 Conclusions and Recommendations 2.1 Conclusions Inherent tension Audit firms are organisations with commercial interests. They are paid by the organisations being audited (audit clients) and they compete with each other to win and retain audit business. This set-up creates inherent tension for auditors. On the one hand, the external auditor must adopt an objective and sceptical attitude towards his audit client in order to serve the public interest of the users of the audit client s financial statements. On the other hand, the auditor aims to provide the best possible service to that audit client in order to win or retain the business of the client. To gain a better understanding of this area of inherent tension, the AFM's review explored auditor independence and the appointment, appraisal, remuneration, and sanctioning of external auditors The appointment, appraisal, remuneration and sanctioning of external auditors The AFM s review highlighted that the extent to which PIE licensees have incorporated the quality of their statutory audits in the appointment, appraisal, and remuneration of external auditors varied among audit firms. In addition, our review brought to light differences in the way PIE licensees have formalised and documented the quality of statutory audits as an evaluation criterion. However, the majority of PIE licensees demonstrably considered audit quality aspects when appointing, appraising and remunerating their external auditors. This is evident from the 46 cases reviewed by the AFM, two of which are included in this report for illustrative purposes. Examples of quality aspects include the results of engagement quality control reviews (EQCR) 7, internal audit file reviews and other quality reviews which were conducted in the past year, credits obtained in the context of continuing professional development, identified violations, and any disciplinary matters. In addition, ten PIE licensees had a sanctions policy in place focused on taking appropriate disciplinary and other action against external auditors violating internal or external rules. PIE licensees imposed approximately 100 sanctions in total against external auditors in Our report includes two examples of PIE licensees imposing sanctions on external auditors. Commercial aspects The appraisal end remuneration of external auditors involves both quality aspects and commercial aspects. Such commercial aspects include entrepreneurship, new business development, profit contribution and cross-selling results, i.e., the sale of other services to audit clients. In the course of its review, the AFM was not able to determine how much weight was given to commercial aspects relative to quality aspects Independence Why an auditor must be independent 7 An EQCR is a review of a statutory audit by an auditor who is not involved in the performance of that audit, to assess whether the external auditor could reasonably have come to the opinion expressed in the auditor s report to be issued. An EQCR is mandatory for all PIE licensees, on the basis of the Supervision of Audit Firms Decree. For non-pie licensees, an EQCR is conducted if certain internal criteria are met. 8

9 An auditor s report provides assurance and contributes to the confidence in financial reporting. An auditor s report is only of value to users if the audit is conducted by an independent auditor. Users must be confident that the auditor has been objective and sceptical, that he has carried out sufficient work, and that he has not let his work or judgement be influenced by other than technical considerations. The auditor must not only be actually independent (independence in fact), but must also avoid the perception that he may not be independent (independence in appearance). Requirements and prohibitions The AFM s review shows that, where requirements and prohibitions are set out in the independence rules, external auditors and audit firms generally comply with such rules. The rules do not allow financial interests in audit clients, employment relationships with audit clients, nor auditors holding management or supervisory positions at such clients. In addition, external auditors conducting PIE audits must observe a seven-year rotation period. Audit firms are required to ensure that such rules are complied with. Partners and staff are required periodically, annually in most cases, to complete an independence statement which is reviewed and followed-up by the independence officer or department. Firms with a large number of listed audit clients have policies and systems for central registration of financial interests in listed audit clients. They identify prohibited financial interests and take action on any violations of the rules. Some firms periodically review the reliability of the information provided by their partners and staff in their independence statements and in the central register of financial interests, using the partners and employees own records. Independence assessment The current auditor independence rules include hardly any explicit requirements and prohibitions for other situations occurring in practice that pose a threat 8 to auditor independence. This concerns, in particular, the provision of services other than statutory audits to audit clients, business or sponsor relationships with audit clients, and long-term relationships with non-pie audit clients. In such situations, the external auditor and the audit firm are required to perform an independence assessment in accordance with a prescribed conceptual framework. This means, in fact, that external auditors and audit firms conduct a self-assessment of their independence by identifying and evaluating threats and taking measures to safeguard their independence where necessary, with the rules leaving ample room for judgement. As a consequence of using a self-assessment framework, assessments carried out in similar situations vary among external auditors and audit firms and so do the outcomes of such assessments. This was evident from the 78 cases reviewed by the AFM, fifteen of which are included in this report for illustrative purposes. The assessment inconsistencies related to: identification of all existing and potential threats to independence in a given situation; the evaluation of such threats; the choice of the situation-specific safeguards to mitigate or eliminate potential threats; and the decision not to enter into a certain relationship with an audit client or to discontinue an existing relationship. As noted above, independence assessments carried out by external auditors and audit firms and their outcomes vary. As a consequence, users of the financial statements and auditor s reports do not know what independence entails in specific situations. Users rely on the framework applied by an individual auditor, or the firm that employs him or with which he is affiliated. This does not mean that 9 8 The threats to auditor independence are fall into the following categories: threats resulting from self-interest, self-review, advocacy, familiarity, and intimidation.

10 the assessment would not be correct. Nevertheless, due to a lack of uniform standards for independence assessments and, as a consequence, their subjective nature, the outcomes of such assessments give ample room for judgement. To ensure that assessments are carried out consistently and their outcomes are more generally accepted, clearer and more restrictive standards are required. The PIE licensees indicated that engagements to provide other services are not undertaken if they would lead to unacceptable threats to independence. The AFM s review has not resulted in a clear understanding of the number of situations where PIE licensees had declined requests to perform other services. Examples To review auditor independence, the AFM s thematic review focused on 171 audit clients in total where audit firms carried out statutory audits in combination with other services of some significance. The fifteen examples included in this report are therefore not representative of the total population of audit clients of the PIE licensees. 2.2 Recommendations For the benefit of the users of financial statements, the AFM supports clearer, unambiguous and more restrictive rules for auditor independence and the appointment, appraisal, remuneration and sanctioning of external auditors. The Netherlands Institute of Chartered Accountants (Nederlandse Beroepsorganisatie van Accountants, or NBA) in November 2010 issued a plan of action ("Lessons Learned from the Credit Crunch") for the profession. As a measure to improve audit quality, this action plan proposes to make quality the main evaluation criterion for the appraisal and remuneration of auditors serving audit clients, and prohibiting commercial incentives such as revenue and cross-selling as evaluation criteria for remuneration. The AFM believes that a clear quality criterion should be developed and included as a requirement in the professional regulations. The NBA has already published a proposal to amend the Dutch Audit Firms Regulation. The AFM s review shows that clear requirements and prohibitions can reduce the risk of undesirable dependencies. Such rules are easier to apply, and reduce the risk of inconsistent application. This does not take away from the fact that self-assessment continues to play an important role in ethical issues. Given that clear requirements and prohibitions are more effective, the AFM supports the position of the Minister of Finance, who prefers clear requirements and prohibitions in this area over the existing conceptual framework, which is based on threats to independence and safeguards against such threats. 9 The AFM recommends that, when developing stricter independence rules, the services provided by audit firms are split into two main categories: 1) services aimed at providing assurance on information provided by the audit client for the benefit of external users of this information, and 2) services for the benefit of the audit client itself. 9 The Minister of Finance has raised this point of view in his combined reaction of 13 September 2011 to the evaluation of the 10 Supervision of Financial Reporting Act, the vision on audit, and the reaction to Mr. Plasterk s Initiative Memorandum.

11 In addition, the AFM believes that it is important that the above categories are clearly defined, eliminating any room for judgement. The AFM believes that the drafting of such stricter independence rules should be the subject of a comprehensive public consultation. Given the importance of independence, any violations of independence rules should be considered explicitly in the appraisal and remuneration of auditors. 11

12 3 Execution of the thematic review In the first six months of 2011, the AFM carried out a thematic review involving all fifteen PIE licensees, including the Big 4 firms and eleven other PIE licensees 10. Those fifteen PIE licensees conduct statutory audits of both PIE audit clients and non-pie audit clients. The AFM s review extended to both categories of audit clients. The PIE licensees serve a majority of the audit market, carrying out approximately 72 percent of the approximately 21,500 statutory audits in the Netherlands, representing approximately 87 percent of total fees from statutory audits in the Netherlands. 11 PIE licensees employ about 40 percent of all external auditors in the Netherlands carrying out statutory audits. 12 The size of the fifteen PIE licensees varies. Figure 1 provides an analysis of the relative size of the fifteen PIE licensees based on the number of statutory audits they conduct. One of the other PIE licensees is a firm that in substance is part of another PIE licensee. 13 That is why, in the remainder of this report, we refer to fourteen PIE licensees. Two of the other PIE licensees have a business model which involves working with so-called affiliated offices (other audit firms, auditing and bookkeeping services providers). 14 Figure 1. Analysis of the size of the fourteen PIE licensees based on the number of statutory audits carried out (source: AFM Monitor Audit firms 2010) The AFM has the statutory duty to monitor compliance with the provisions set by or pursuant to the Audit Firms Supervision Act (Wet toezicht accountantsorganisaties, or Wta) and, in particular, the provisions relating to independence, the system of quality control and the quality assurance policies (including the policy regarding the appointment, appraisal, remuneration and sanctioning of external auditors). 10 Accon avm controlepraktijk B.V., Baker Tilly Berk (N.V. and B.V.), BDO Audit & Assurance B.V., Extendum Audit B.V., Grant Thornton Accountants en Adviseurs B.V., HLB Van Daal en Partners N.V., HLB Schippers Beheer B.V., Mazars Paardekooper Hoffman Accountants N.V., PKF Wallast and SMA Accountants N.V. 11 Source: AFM Monitor Audit firms Source: AFM Monitor Audit firms Baker Tilly Berk B.V. (affiliated with Baker Tilly Berk N.V.) SMA Auditors N.V. and Extendum Audit B.V.

13 The aim of the AFM s thematic review was to gain an understanding of how independence and the appointment, appraisal, remuneration and sanctioning of external auditors are addressed in practice. Our review was exploratory in nature, and did not focus on assessing the level of compliance with laws and regulations, or identifying specific violations. However, our review highlighted a number of issues, particularly related to the adequacy of standards. The results in this report should be viewed in this light. The thematic review 'Incentives for Audit Quality' consisted of five phases: 1. General information request The AFM made a general request for information to the PIE licensees relating to the period 1 January 2009 to 31 December 2010, requesting the following information: the nature and extent of the situations 15 where there may be a threat to auditor independence (for the entire audit client base); any violations of independence rules and/or complaints about independence related to audit clients; further details about the external auditors registered on 31 December 2010; the extent to which quality is incorporated in the appointment, appraisal, remuneration and sanctioning of external auditors; the nature and extent of sanctions against external auditors. 2. Specific information requests Based on an analysis of the information provided by the PIE licensees following our general information request, the AFM requested additional specific information for further inspection. To review auditor independence, the AFM made a selection for further inspection based on the nature and extent of threats to independence in 2009 and 2010 of 171 audit clients in total, comprising 43 (25%) PIEs and 128 (75%) non-pies. The audit clients selected were audit clients with whom the audit firm or the external auditor had a relationship that could threaten their independence. Figure 2 provides an analysis of the selected audit clients by firm type (Big 4 firm or other PIE licensee) and by type of client (PIE or non-pie). The AFM requested specific information for all 171 audit clients about combinations with other services, for 47 audit clients about existing business relationships, and for 15 audit clients about the sponsor relationships that had been reported. Regarding the other situations listed in Section 1.2, the AFM requested specific information from an average of nine audit clients. This specific information included audit file papers, independence assessments, time sheet information, invoices, contracts and reports. 15 The requested information related to the following: financial interests, business relationships, employment and secondment relationships, staff entering employment with audit clients, management and supervisory positions, family or close personal relationships, combinations of statutory audits and other services provided, gifts from audit clients, gifts to audit clients, sponsoring, and long-term relationships. 13

14 32 PIEs Big 4 firms: non-pies 171 audit clients 11 PIEs Other PIE licensees: non-pies Figure 2. Analysis of selected audit clients by firm type and type of client In addition, the AFM requested further information from the PIE licensees about the appointment, appraisal, remuneration and sanctioning of the 865 external auditors employed by the PIE licensees and registered with the AFM on 31 December This information included the records with the considerations involving appointments, appraisal, remuneration and sanctions. 16 Figure 3 sets out an analysis of the number of external auditors by PIE licensee. The AFM performed a high-level review of the documentation of the PIE licensees with respect to concrete appointments, appraisals, remuneration and sanctions in the period 2009 to 2010, and then selected specific examples for further inspection. Figure 3. Analysis of the number of external auditors by PIE licensee selected for review 3. On-site inspection The AFM conducted on-site inspections at all PIE licensees to gain an understanding of how external auditors and audit firms had dealt with threats to their independence and how they had dealt with the appointment, appraisal, remuneration and sanctioning of external auditors. In addition, the AFM discussed with the relevant officials of the PIE licensees how the information provided to the AFM had been prepared. The AFM also discussed the applicable internal policies and procedures with them. Furthermore, during on-site inspections, the AFM reviewed all 16 The AFM s review was aimed at all registered external auditors, even if these external auditors were not actually responsible for conducting statutory audits, and in that sense were 'inactive'. Approximately 86 percent of the external auditors in 2010 were actually responsible for conducting statutory audits. At the Big 4 firms, about 91 percent of the registered external auditors were active as such; for the other PIE licensees, this was approximately 74 percent.. 14

15 relevant relationships between the audit firm or auditor and the selected audit clients. The AFM performed a high-level review of the information pertaining to the appointment, appraisal, remuneration and sanctioning of external auditors, including documents from personnel files and records of violations. 4. Written confirmation of information with audit firms The AFM confirmed with the PIE licensees the accuracy and completeness of the factual information gathered in the course of its review. Firstly, the written confirmation included a description of the AFM s general observations regarding independence and the appointment, appraisal, remuneration and sanctioning of external auditors. Secondly, the confirmation included a summary of the concrete cases reviewed by the AFM in more detail and selected as illustrative examples. This involved a total of 78 case studies relating to independence and 46 case studies relating to the appointment, appraisal, remuneration and sanctioning of external auditors. The AFM requested the PIE licensees to inform the AFM of any changes to the audit firm s quality control system, or any other measures taken as a result of our review. The written exchanges between the AFM and the PIE licensees are confidential and are not publicly available. The examples in Chapters 4 and 5 have been derived from actual situations encountered at PIE licensees and reviewed by the AFM in the course of its thematic review. The case studies were confirmed with the individual PIE licensees and have been included for illustrative purposes. 5. Public report The AFM presented the preliminary findings of its thematic review during a meeting with the PIE licensees on 5 September This was followed by a discussion of our findings with the NBA. The anonymised results of our thematic review are included in this report, which is available on the AFM s website. 15

16 4 Results by theme 4.1 Appointment, appraisal, remuneration and sanctioning On 31 December 2010, 865 auditors in total were employed by or affiliated with PIE licensees and registered as external auditors with the AFM, including 603 auditors working at the Big 4 firms and 262 auditors working at other PIE licensees. About 91 percent of the registered auditors working at the Big 4 firms were active as such. For the other PIE licensees, this was about 74 percent. At most PIE licensees, the role of external auditor is performed at various job levels within the audit firm. Many external auditors are partners. But there are also external auditors holding the position of, for example, director or executive director, or audit manager or senior audit manager. Partners are shareholders or co-owners of their audit firms, while other external auditors are often employed by the audit firm. Approximately 67 percent of the external auditors were audit firm partners (Big 4 firms: 71%; other PIE licensees: 58%) Appointment The PIE licensees in 2010 appointed 66 auditors to the position of external auditor, and removed 66 auditors registered as an external auditor from the AFM s register. The appointment as an external auditor may be directly linked to an appointment to a particular position, but can also be a separate decision. Ten PIE licensees made appointments via a separate decision. Audit quality played a role in the appointment of external auditors at all PIE licensees. However, the extent to which this was formalised varied. Of the fourteen PIE licensees, ten based their decisions on information available within the organisation. This included results from internal quality reviews, engagement quality control reviews, recorded violations and other relevant information. Four firms specifically ensured that potential candidates for the position of external auditor were included in internal quality reviews, making sure that relevant information was available prior to the appointment decision. At least ten PIE licensees collected this information, insofar available, accompanied by a recommendation from the compliance officer and/or the person responsible for the audit firm s professional practice department. One PIE licensee allowed newly appointed external auditors to perform statutory audits on 'low risk' audit clients only. Another firm provided additional guidance and training for new external auditors. Four PIE licensees took standard quality measures after the appointment of external auditors, i.e., audit files of newly appointed external auditors being included in engagement quality reviews, or in periodic internal quality reviews. Example 1 illustrates a situation where audit quality played a clear role in the appointment of an external auditor. Example 1: Appointment as an external auditor Early 2010 an audit manager was appointed as an external auditor by the responsible director on the proposal of the compliance officer. The compliance officer s proposal was based on his inquiry, which considered the following: 16

17 Theoretical training - the compliance officer s report noted that the manager had completed the training for registered accountant. Practical training - the report noted that, since 2006, the manager had been involved in audit engagements of various sizes and in various business sectors. In addition, the report included the audit manager s time spent conducting audits in 2008 and 2009, referring to the various sectors in which the manager had worked. The inquiry also noted that the manager had served as an audit senior accountant and as a second auditor. Based on this information, the compliance officer concluded that the manager had been sufficiently involved in carrying out audit engagements in 2008 and 2009 and had performed his work in roles of sufficient seniority. Views of other external auditors the report noted that the compliance officer had, in general terms, made inquiries with two external auditors regarding the suitability of the audit manager as an external auditor. Both external auditors had responded positively. Inquiry into the practical execution of audit engagements - the report noted that the assessment of the practical execution of an engagement was somewhat difficult because the audit manager s work had been carried out under the responsibility of other external auditors. The assessment of the quality of practical execution consisted of a file review and an interview regarding the preparation and planning for the engagement selected for file review. Based on that, the compliance officer concluded that the manager had sufficient knowledge of the practical execution of audit engagements, was able to apply the firm s audit methodology sufficiently, and that he exercised sufficient professional scepticism, appropriate for an external auditor Appraisal Twelve PIE licensees combined the appraisal of external auditors with the overall performance appraisal of the respective persons in their role as a partner, director or executive director, audit manager or senior audit manager at the audit firm. The role of external auditor was therefore not separately assessed. Five PIE licensees used an almost uniform evaluation system for external auditors, regardless of their position within the audit firm (partner or non-partner). At seven PIE licensees, the form of appraisals of external auditors depended on the position of the person involved. Whilst non-partners were appraised often using fixed procedures and standardised forms, the appraisal of partners was usually relatively unstructured. One PIE licensee appraised all partners in their office on a joint basis rather than on an individual basis. In the past year, two PIE licensees did not systematically appraise the performance of their external auditors. The PIE licensees appraised the overall performance of their external auditors in terms of various achievements and skills. The extent to which PIE licensees consistently included audit quality, and particularly the input of, for example, the audit firm s compliance officer or professional practice department in the appraisal of external auditors varied from firm to firm. Four PIE licensees considered audit quality implicitly and in general terms in the appraisal of external auditors. However, other PIE licensees measured, recorded and demonstrably included more concrete audit quality aspects in the appraisal of external auditors. Such concrete quality aspects included the results of engagement quality control reviews, internal file reviews and other quality reviews carried out in the past year, credits obtained in the context of continuing professional development, any identified violations, and any disciplinary matters. Three firms have set up a central and systematic system for collecting all quality aspects relevant to the appraisal of each external auditor. Such records also provide an overview of the quality of external auditors, enable comparison between individuals, and 17

18 can also provide a basis for company-wide measures. One firm gives compliments designed to reward activities with a positive contribution to audit quality, such as providing training or providing support to colleagues on complex engagements. These compliments are also included in the appraisal of external auditors. However, the AFM found that, in some cases, audit quality deficiencies identified by a few PIE licensees had not been taken into account in the appraisal of the external auditors concerned. Example 2 illustrates a situation where this occurred. Example 2: Appraisal of an external auditor In 2009 the audit firm concerned imposed a sanction on an external auditor. The person concerned had not carried out sufficiently detailed audit procedures in the 2007 statutory audit of an audit client. The sanction comprised an internal coaching programme. The audit firm s board subsequently ordered file reviews of three 2008 statutory audits carried out under the responsibility of the auditor. These reviews highlighted areas for improvement in two of the three audits. Based on their findings, the firm s reviewers concluded that the audit file documentation of key elements of the audit (adequate understanding of the company, sufficient audit evidence supporting the auditor s report) required improvement. One of the specific findings was that in one case, the auditor concerned had initially issued an auditor s report on the balance sheet only, rather than an unqualified auditor s report on the financial statements. Subsequently, the auditor revoked the auditor s report on the balance sheet and then issued an unqualified auditor s report on the financial statements. The results of the file review were reported to the board of the audit firm mid However, the results were not reflected in the external auditor s 2010 appraisal form. Because the appraisal of a person in his role as an external auditor generally coincides with the overall performance appraisal of that person in his role as a partner, director or executive director, audit manager or senior audit manager, twelve of the fourteen PIE licensees included commercial aspects in the appraisal of external auditors. These aspects are defined in terms of entrepreneurship, commercial attitude, personal profit contribution, fees, margin, work in progress, write-downs of accounts receivable, billable hours, write-downs of work in progress, new business, organic growth in existing customer business, fee growth from new customer business, cross-selling (selling other services) and productivity. In the course of this inspection, the AFM was not able to determine how much weight was given to commercial criteria relative to quality aspects Remuneration Nearly all PIE licensees, except for two firms, determined the remuneration of their external auditors in a way that is linked to the position held by their auditors. Partner remuneration mainly comprises their share in the firm s profits, whilst the remuneration of non-partners usually comprises the auditor s salary. Twelve PIE licensees had a remuneration policy where the remuneration of external auditors was to a greater or lesser extent variable. Total partner remuneration was linked to total profits made. Partners at a majority of the PIE licensees shared in the profits earned on other services. Depending on seniority or the achievement of agreed targets, including commercial performance (comparable with the commercial aspects involved in the appraisal of auditors), partners were awarded more or less profit credits determining the level of their individual total remuneration. The variable remuneration of non-partners was usually in the form of a bonus. 18

19 Half of the PIE licensees based the remuneration of their external auditors in part on the performance appraisal of their external auditors. For the other half this was not the case. In the case of three PIE licensees, a negative audit quality assessment had a direct negative impact on the remuneration of the external auditors involved. In addition, the AFM occasionally found that external auditors with an 'average' quality score and a 'very good' score on commercial performance had received a bonus, whereas external auditors scoring 'very good' on quality, but 'average' on commercial performance had not received any additional remuneration Sanctioning Ten PIE licensees used a sanctions policy including disciplinary and other measures against external auditors violating internal or external rules. These measures include mandatory participation in training or other forms of education, cutting the variable component of remuneration, demotion (from partner to non-partner), imposing a warning, reprimand or suspension, imposing a ban on acting as an external auditor (including revocation of the auditor s registration with the AFM) and the annulment of the employment, affiliation or management agreement with the respective external auditors. In 2010 the PIE licensees imposed approximately 100 sanctions in total on external auditors. The AFM found that some PIE licensees had not demonstrably taken recorded violations or sanctions into consideration in the appraisal and remuneration of external auditors. In those cases, the technical qualities of the external auditor were rated 'very good' or the external auditor received a financial bonus, despite violations or sanctions. Example 3 illustrates a situation where the audit firm recorded the external auditor s violations in the register of violations, and then imposed sanctions on this external auditor. Example 3: Sanctioning of an external auditor The external auditor, a partner of the audit firm, headed one of the audit firm s local offices. The 2010 register of violations included the following violations by the auditor: The external auditor issued the auditor s report accompanying an audit client s financial report prepared for publication purposes prior to completion of the engagement quality control review (EQCR). The external auditor dated and issued the auditor s report before completion of the audit concerned and before all audit evidence had been obtained (NV COS ). The external auditor issued the auditor s report prior to completion of the EQCR (Article 21 of the Audit Firms Supervision Decree). The quality control reviewer had explicitly indicated to the auditor that the file still did not meet the requirements. Exceeding the 60-day period for finalisation of the audit file. Insufficient evidence in audit file to support rotation selection. Inadequate audit file documentation. The compliance officer reported the external auditor to the audit firm s board referring to the first two of the above violations with a view to applying the sanction rules to the auditor concerned. One of the compliance officer s grounds was that the external auditor had repeatedly violated the rules. The 19

20 compliance officer requested the board in writing to evaluate the case considering the sanction rules and to impose an appropriate sanction, taking into account earlier violations. The audit firm s board in 2010 gave a written warning to the external auditor. The board urged the external auditor in writing to adhere to the applicable legal requirements and/or current policies, procedures and technical quality requirements. A repeat violation would be followed by a more severe sanction or an additional sanction. The letter showed that the external auditor had acknowledged his failure to apply the relevant rules adequately and had indicated that he would take measures (the senior manager involved was transferred from the firm s audit practice to the compilation practice; an experienced manager from the audit practice was transferred to the local office concerned). In addition, the external auditor assured the audit firm s board that such violations would not occur in the future. The audit firm s board also concluded that the local office s audit practice needed to be further strengthened to ensure audit quality. That is why the board encouraged the transfer of a second audit practice manager to the external auditor s local office. 20

21 4.2 Independence The following section provides the results of our review of auditor independence covering 2009 and Combinations of statutory audit and other services An audit firm is not allowed to carry out statutory audits of PIE audit clients if, at any time during the previous two years, it compiled the financial statements of the client concerned, or, during the financial year to be audited, it keeps or has kept the accounting records or sets up or has set up the audit client s accounting records (Article 23 of the Wta). In addition, the NBA s Further regulations on auditor independence (Nadere voorschriften onafhankelijkheid, or NVO) set out some combinations of services resulting in unacceptable threats to independence. Where this is the case, the audit firm is not allowed to provide the other services. Such unacceptable threats are: Valuation services with a direct material impact on the financial statements of the audit client and where valuation requires a significant degree of judgement. Certain corporate finance services, including recommending, or trading in, equity or debt instruments following equity or debt offerings of an audit client, or underwriting such offerings, or performing transactions on behalf of an audit client. Certain legal services, including acting on behalf of the audit client in the resolution of a dispute relating to matters that may reasonably be expected to have a material impact on the financial statements of the audit client. Certain activities concerning the design and implementation of financial or other information systems generating information that will eventually be included in the audit client s financial statements. Certain services related to the recruitment of staff for key financial and administrative positions at PIE audit clients. And there is the general rule that the external auditor may have no involvement in the audit client s decision-making process. In situations that are not prohibited or regarded as unacceptable, the auditor is required to carry out a self-assessment to evaluate whether he is independent. Where the external auditor identifies a threat to his independence that is other than clearly insignificant, he should at least apply adequate safeguards to eliminate the threat or mitigate it to an acceptable level. This can also imply that he does not undertake the work requested. The NVO set out the following safeguards for auditors: segregation of roles and responsibilities between the audit engagement and the other services provided to the audit client or a third party affiliated with the audit client; consultation with the independence officer responsible for independence issues within the audit firm; consultation with an independent auditor from outside the audit firm itself, or obtaining advice from the professional body; review of the audit work performed by an audit partner who is not involved in that audit engagement or those other services provided to the audit client or a third party affiliated with the audit client. The AFM reviewed the extent to which the PIE licensees had carried out statutory audits in combination with the provision of other services to audit clients, or third parties affiliated with the audit 21